Table of Contents

Basic Planning Concepts ........................................................................................................... 2

The Planning Process ............................................................................................................ 2

Planning Variables.................................................................................................................. 2

Type of Decisions ................................................................................................................... 3

Benefits of Planning................................................................................................................ 3

Break-Even Analysis .................................................................................................................. 4

Graphical Method ................................................................................................................... 4

Algebraic Method ................................................................................................................... 6

Variations on the Basic Model ................................................................................................ 6

Leverage Analysis ...................................................................................................................... 7

Operating Leverage ................................................................................................................ 7

Financial Leverage ................................................................................................................. 8

Total Leverage ....................................................................................................................... 9

pg. 1
Basic Planning Concepts
Company is an entity that will always strive to achieve its goals. To achieve that goals
company must be prepared in facing unfavorable conditions. One of the key functions of
managers is planning. And it involves thinking out of the possible consequences of decisions.
What is a plan? A plan is a manager’s proposal on how to achieve an intended result

The Planning Process

The setting of an overall goal that will guide all the components of the plan, is the start of
Planning Process. This goals varies and it is the decision of the stockholder, represented by the
chief executive officer. After the goals is set, operating managers prepare the plan that will support
those goals. The organizations ensures that work is coordinated by higher level managers and it
is divided accordingly.

The chief operating officer then coordinates the detailed plan with the operating managers.
Then the chief executive officer will reviews the plan. The CEO may decide on sending back the
plan to the COO for revisions. “The company could not raise the funds required to implement the
plan” is one of the more common reasons for a revisions on the plan. After the revision stage, and
once approved, the plan would guide the company’s future decisions and operations.

Planning Variables
Variables in the planning process are classified according to their nature and controlment
by the manager, and it is as follows:

1. External or Internal Variables.

a. External Variables are factors that are not usually within the influence of the
company. Examples the Economy, interest rates, foreign exchange rates, industry
and technology.
b. Internal Variables are factors that are usually within the influence of the company.
Ex. Level of inventory, customer credit policy, volume of production, and amount
of debt financing.
2. Non-controllable or Controllable Variables

RISK: All plans are subject to the risk that actual performance will deviate from the plan

pg. 2
Type of Decisions
There are 3 key performance variables that are within the control of operating
management decisions:

1. The volume of sales or business activity.

2. The sources of financing.
3. The investment in fixed asset.

The starting point of planning is the setting of a target sales or level of activity. The different
units of a business could not possibly plan without a clear target sales or activity level. To fulfill
the volume of sales the company might want to invest in the fixed assets for production and
marketing. Then the finance manager plans not only the amount but also the source of financing.
Because it matters very much whether such financing comes from owners or from creditors.

Benefits of Planning
Plans enable management to perform the following:

1. Communicate the goal of the company and coordinate decisions from all units.
2. Measure performance and provide incentives.
3. Require managers to think out aspects of their future operations.

Planning allow the top management to communicate overall goals to the lower
management. Even if there are issues between the top and lower management, it can be
discussed and reconciled in the planning process. Planning also allow all the units to see the
bigger picture, because without plan every unit will only see the consequences of it’s owns
actions. When all the units can see the “whole picture” they can assist each other out. It will also
reduce conflicts and builds a good working environment.

By comparing actual performance with plans, managers are able to isolate the successful
from the less successful units. Then the company should provide incentives to successful
managers based on actual performance relatives to plans. By measuring the achievement the
managers should make further assessment and take actions, such as:

1. Attend to a possible problem area.

2. Exploit a potential opportunity to further increase revenues of reduce costs.
3. Revise the plan because it is unrealistic.

pg. 3
Break-Even Analysis
Management monitors financial plans through the financial reporting system, and plans
follow the financial statement formats. Break-even analysis shows the likely costs, revenues and
profits at different levels of production and sales. Break-even analysis also shows the different
levels of operations at which the business loses money, recover its cost, or make profit.

Break-even point is the level of operations at which total revenue equals total costs. The
break-even point is a minimum goal. It is not an objective of managers to achieve zero profit. It is
useful though as a reference in determining the profit possibilities for a company. Below break-
even volume, the company incurs losses. Above the break-even point, the business enjoys profits.

To use the break-even analysis and leverage analysis, the analyst need to classifies costs
in two, namely:

1. Fixed costs
The cost that will remain the same regardless of the level of operation. Usually this costs
are related to the setting up of production capacity and management of the business.
Example depreciation, rent, insurance, salaries of managers.
2. Variable costs
The cost that will change with the level of operations. Assuming that costs are linear
functions of volume, variable costs increase in a fixed proportion relative to the level of
operations. Example wages of factory workers, raw materials, supplies, maintenance,
component parts, fuel, and sales commission.

Graphical Method
The graph represent two lines, total cost and total revenues. The intersection of the two
lines represents the break-even point. The vertical axis plots the amount of costs and revenues.
The horizontal axis plots the level of operations in amount or in units of production and sales. The
blue line represents the total expenses. Notice that the line has a positive or upward slop that
indicates the effect of increasing variable expenses with the increase in production. The straight
line in red color represents the total annual fixed expenses of $15,000. The green line with positive
or upward slop indicates that every unit sold increases the total sales revenue.

pg. 4
 The total revenue line and the total expenses line cross each other. The point at which
they cross each other is the break-even point. Notice that the total expenses line is above the
total revenue line before the point of intersection and below after the point of intersection. It tells
us that the business suffers a loss before the point of intersection and makes a profit after this
point. The break-even point in the above graph is 2,000 units or $30,000 that agrees with the
break-even point computed using equation and contribution margin methods above.

The difference between the total expenses line and the total revenue line before the point
of intersection (BE point) is the loss area. The loss area has been filled with pink color. Notice
that this area reduces as the number of units sold increases. It means every additional unit sold
before the break-even point reduces the loss. The difference between the total expenses line and
the total revenue line after the point of intersection (BE point) is the profit area. The profit area
has been filled with green color. Notice that this area increases as the number of units sold
increases. It means every additional unit sold after the break-even point increases the profit of
the business.

pg. 5
Algebraic Method
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
𝐵𝑟𝑒𝑘𝑒𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 (𝐵𝐸𝑃) =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 (𝐶𝑀) = 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

The algebraic method is a more precise way of analyzing the break-even point. But it is
unable to show management an overall appreciation of the potential profits and losses that a
graphical presentation might show. Analyst must have an accurate cost analysis, because first
they have to classify costs into fixed and variable costs. Using the algebraic method and
information from the graph on previous section, the break-even point is:

𝐶𝑀 = $ 15 + $ 7.5 = $ 7.5

$ 15,000
𝐵𝐸𝑃 =
$ 7.5
𝐵𝐸𝑃 = 2000 𝑢𝑛𝑖𝑡𝑠

Variations on the Basic Model

Determining whether costs are fixed or variable are the most common problem. The
following types of costs require further analysis:

1. Semi-variable costs.
It is a costs that are both fixed and variable costs. Example of this are power, advertising,
repairs, professional fees. In cases like this analyst first need to break up the cost to fixed
and variable cost. One of the method to break up the cost is “high-and-low point” method.
The formula are as follows:
𝐶𝑜𝑠𝑡 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑠𝑡 𝑣𝑜𝑙𝑢𝑚𝑒 − 𝐶𝑜𝑠𝑡 𝑎𝑡 𝑙𝑜𝑤𝑒𝑠𝑡 𝑣𝑜𝑙𝑢𝑚𝑒
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 =
𝐻𝑖𝑔ℎ𝑒𝑠𝑡 𝑣𝑜𝑙𝑢𝑚 − 𝐿𝑜𝑤𝑒𝑠𝑡 𝑣𝑜𝑙𝑢𝑚𝑒
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 − [𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟𝑢𝑛𝑖𝑡 × 𝑉𝑜𝑙𝑢𝑚𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛]
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 + [ 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟𝑢𝑛𝑖𝑡 + 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠
2. Costs with random behavior.
For the costs which behave randomly and could not be identify the fixed and variable
components. The management need to determine the total cost using statistical analysis.
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑎𝑙𝑝ℎ𝑎 + (𝑏𝑒𝑡𝑎 × 𝑣𝑜𝑙𝑢𝑚𝑒 𝑜𝑓 𝑏𝑢𝑠𝑖𝑛𝑒𝑠𝑠)

pg. 6
Leverage Analysis
There are two types of leverage that could impact the income of a company. It is operating
leverage and leverage.

Operating Leverage
The concepts of operating leverage pertains to the set-up costs of a business. It is the
ratio of a company’s level of fixed costs to total costs at different levels of sales or activity. A
company has a high operating leverage if its costs consist mainly of fixed costs. For example a
company that have a higher fixed costs like plant, or plane will have a high operating leverage.
The company that have a higher variable costs such as high labor will have a low operating
leverage.

Operating leverage is the sensitivity of a company’s operating profits to the change in

sales caused by intensive use of fixed assets. To measure operating leverage, degree of
operating leverage (DOL) is used. Sin fixed cost does not change with output , DOL will have
values at different volumes of output, as follows: (a) positive above the BEP volume, (b) negative
below the BEP volume, and (c) zero at zero sales volume. DOL decrease as the volume of output
increases. The formula for DOL:

𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡

𝐷𝑂𝐿 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡

𝐶𝑀
𝐷𝑂𝐿 =
𝐸𝐵𝐼𝑇

𝐶𝑀
𝐷𝑂𝐿 =
𝐸𝐵𝐼𝑇

Example: Two companies producing identical product for the same markets have the
following costs and sales levels:

ABC CO. 10% INC ABC CO. 10% INC

TOTAL SALES 2,000,000 2,200,000 2,000,000 2,200,000

TOTAL VARIABLE COSTS 500,000 550,000 1,200,000 1,320,000
CONTRIBUTION MARGIN 1,500,000 1,650,000 800,000 880,000
FIXED COST 1,000,000 1,000,000 300,000 300,000
OPERATING INCOME 500,000 650,000 500,000 580,000
DOL 3 2.538462 1.6 1.517241379

pg. 7
 2,000,000 − 500,000
𝐷𝑂𝐿 (𝐴𝐵𝐶 𝐶𝑜) =
2,000,000 − 500,000 − 1,000,000

1,500,000
𝐷𝑂𝐿 (𝐴𝐵𝐶 𝐶𝑜) =
500,000

𝐷𝑂𝐿 (𝐴𝐵𝐶 𝐶𝑜) = 3.0

We then can calculate the increase or decrease of operating income using DOL and sales
performance. If there’s an increase of 10% to the total sales in ABC Co. we can calculate that
they are going to have an increase of operating income by 30%. Because ABC Co, have DOL
value of 3.0. Because the XYZ Co. only have DOL value of 1.6, if there’s an increase of 10% to
the total sales then the increase of operating income will only be 16%. Each time there’s an
increase in total sales the value of DOL will decrease and vice versa. The value of DOL will
increase the closer they are to the BEP.

If a company have a high operating leverage then it means the company have bigger
chance to increase their operating income without having to increase their sales exponentially.
But it is a double edge sword, because just a little decrease in sales will also decrease the
operating income of the company exponentially. High operating leverage company also have a
major disadvantage where if the total sales plummeted, the high fixed costs will still need to be
paid and losses might occurs. But in a low operating leverage company they don’t have this
disadvantages because most of their costs of is from variable costs that depends on the total
sales.

Financial Leverage
Financial leverage analyze company assets and how the company finance those assets.
Financial leverage which is also known as leverage or trading on equity, refers to the use of debt
to acquire additional assets. The use of financial leverage to control a greater amount of assets
(by borrowing money) will cause the returns on the owner's cash investment to be amplified. A
company with zero debt has a DFL of one. Degree of Financial Leverage (DFL) is used to
measure financial leverage. The formula for DFL is as follows:

𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒

𝐷𝐹𝐿 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

pg. 8
 𝐸𝐵𝐼𝑇
𝐷𝐹𝐿 =
𝐸𝐵𝐼𝑇 − 𝐼

Examples. ABC Co. and XYZ Co. income and financing expenses for the year are as
follows:

ABC CO. 10% INC XYZ CO. 10% INC

OPERATING INCOME 500,000 550,000 200,000 220,000
INTEREST EXPENSE 140,000 140,000 0 0
EBT 360,000 410,000 200,000 220,000
INCOME TAX 126,000 127,750 70,000 70,700
NET INCOME 234,000 282,250 130,000 149,300
DFL 1.3888889 1.3414634 1 1

500,000
𝐷𝐹𝐿 (𝐴𝐵𝐶 𝐶𝑜. ) = = 1.39
360,000

220,000
𝐷𝐹𝐿 (𝑋𝑌𝑍 𝐶𝑜. ) = =1
220,000

A DFL value of 1.39 means that an increase in operation income will the net income by
1.39. So if there is an increase of 10% in operating income then net income will increase 13.9%.
Stockholder in a company with a high financial leverage will have a high ROI because most of the
asset are finance through liability. But the same company will also have a low ROA because they
incurs interest for the debt.

Total Leverage
Total leverage is the combination of the operating and financial leverages of a company.
While operating leverages concerns are the recovery of fixed cost without financing costs.
Financial leverage concerns are the capacity of operating income to pay for financing expenses.
If DFL is negative, total leverage is also negative. This signals the need for management either
to reduce fixed costs or to reduce debt. The combined effect of these two factors is called the
degree of total leverage (DTL). The formula for DTL is as follows:

𝐷𝑇𝐿 = 𝐷𝑂𝐿 × 𝐷𝐹𝐿

𝐶𝑀
𝐷𝑇𝐿 =
𝐸𝐵𝐼𝑇 − 𝐼

pg. 9